The importance of interest rates

I have written many times about forlorn attempts by central bankers to “stimulate” the economy by applying the twin practices of quantitative easing and lowering interest rates.

It is clear, beyond a shadow of doubt, that these policies simply do not work. The only surprise is that, despite all the evidence, their perpetrators persist and do not give up.

The theory is that if the central bank creates bonds for the Treasury to buy and then ‘monetise’ into circulation, the commercial banks will be encouraged to lend the new money; citizens will be encouraged to borrow and spend; new businesses will spring up; and existing businesses will grow and be encouraged to expand their operations.

Since no one apart from the benighted central banks still believe this fairy tale, the problem is therefore one of lost credibility. The entire panoply of economic manipulators is so palpably inept that what may still make sense to the Treasury and the central bank does not make sense to the people. They have lost what little trust they had in their economic guides, even if they lack a technical understanding of the mechanics of what these wizards are trying to pull off. This lack of trust is now an emotional rejection of policies that may well be rational, but in reality make matters visibly worse. Society having reached the stage of disbelief, there is now no going back, and the unwinding will run its course.

Impossibility of economic calculation

As a business citizen, you will at first be tempted by the lure of cheap credit as the answer to a maiden’s prayer. But you can’t even begin to prepare the projections you need to justify a business expansion if you don’t trust the government’s monetary policy. If you base your forecasts on the availability of cheap debt, can you rely on it remaining cheap? If your business plan requires the import of raw materials or capital goods will the volatility of the currency leave you with higher repayment costs? If you are an exporter, can you safely rely on the purchasing power of what you will be paid?

Result? Watch and wait, maybe, but you certainly will not spend or commit to spending.

That’s one reason why money creation, as a means of stimulating the economy, does not work. Only today we read that the Bank of Japan has disappointed the markets with only a “modest” increase in “monetary stimulus” – doubling its annual spending on corporate bonds. As one securities firm put it, “the BoJ won’t admit it, but it has now reached the limits of QE and negative rates”.

Interest rate suppression

What about its partner-in-crime, the deliberate, systematic and relentlessly contrived suppression of interest rates? It’s amazing how long central bankers can drag out the agony: from 2% you can go to 1.5%, then 1%, then 0.5% (where it stuck for years) and now, lo and behold, the financial mandarins are talking about 0.25%. That’s here in the UK. But why stop there? Why not go into negative territory, as in Japan, and charge depositors for the service of “looking after their money”? If you have £1,000 you can deposit it in the bank, which will promise to give you £950 in a year’s time. A bargain!

Again, the Keynesian origin of this insane ploy is that if you don’t spend it we’ll take it from you. After all, it’s obvious that, given a long enough period, your deposit money will disappear altogether. No surprise that it’s boom-time for sales of domestic safes in Europe!

Keynes held that demand is god. If there is enough demand, somehow the workings of the economy will ensure that the demand is satisfied. But since people are evidently far too stupid to see this, the state had to take over and determine the size of the money supply - and the rate of interest. Thus did the rot set in.

Good economics tells us that production is needed to satisfy demand. Demand, after all, is everywhere. There can never be a shortage of demand if there are people. While that is a statement of the obvious, production is not obvious. It requires human endeavour; it must be created.

Savings - the key

Money and wealth are not synonymous. Wealth is the accumulation of savings, and savings are what is left after wages and costs of production have been settled. Therefore sound business start-up capital comes from savings – not necessarily yours, in which case it will represent borrowings, and there is nothing wrong with that. But at what rate of interest?

All over the world interest rates have been forced lower and lower. The idea of freedom from the bondage of having to pay interest is sheer nonsense – a fool’s paradise. Interest rates arise out of our nature as human beings. Determination of interest rates is a behavioural issue. People may prefer their desires to be met sooner rather than later. I might offer to let you have a loan of £10,000 in 10 years’ time, but if you want it now you may have to accept a discount and settle for £8,000. Interest is therefore “implied in the logic of human action”, as an Austrian economist might put it.

The “time preference”, the desire to consume sooner rather than later, manifests itself in the interest rate. The greater the time preference (the more urgently I need the money now) the higher the rate of discount applicable.

The central banks’ attempt to annihilate interest is therefore a disastrous error: credit markets have the crucial function of channelling resources from savers to investors, and hence establishing equilibrium between them, enabling both to contribute to wealth creation in the community